Seeking to lessen the impact of recent federal tax law changes in Connecticut, Gov. Dannel P. Malloy wants to allow municipalities to set up charitable organizations so taxpayers can continue to write off the full amount of their local property taxes.
In a direct challenge to tax changes recently signed into law by President Donald Trump, the governor’s plan would effectively allow taxpayers to reclassify their property tax payments as charitable donations. The tax reform law enacted by Congress last year places a $10,000 cap on state and local tax deductions but has no cap on the deduction for charitable donations.
Under Malloy’s proposal, taxpayers would receive their local tax bill, make a donation to their city or town’s charity and receive an equal tax credit back. For example, someone with a $12,000 tax bill could instead donate $12,000 to the town’s charitable organization and owe nothing in taxes.
Those charities would in turn use the donations to fund town or city services that are usually paid for by tax dollars and taxpayers would itemize their returns and claim the charitable deduction. The only loser in the equation would be the federal government, which would receive less in taxes.
The Connecticut strategy, designed to assist wealthier taxpayers who typically come from the high-tax states like California and much of the Northeast, is one of a number of ideas that Democratic governors have been discussing in the aftermath of the tax code changes enacted late last year.
Last week, Malloy joined with the governors of New Jersey and New York to announce they planned to sue the federal government over the changes to the deduction, arguing that it treated their states unfairly.
Some tax experts said the Malloy tax plan won’t survive scrutiny by the Internal Revenue Service and the courts.
“The IRS has a substance-over-form doctrine,” said Jared Walczak, a senior policy analyst at the nonpartisan Tax Foundation. “The IRS cares about what something functionally is, not what you call it, not how you frame it. Simply calling this a charitable contribution when in fact it’s just a recharacterization of tax payments is not going to fool the IRS.”
Walczak also pointed to guidance from the IRS regarding charitable deductions which says that if taxpayers receive a benefit because of their donation — and he argues a local property tax credit would fit that description — they can deduct only the amount that exceeds the value of the benefit received.
“If you receive a fully offsetting credit, the actual charitable value [of the donation] is $0,” Walczak said.
Richard Pomp, a professor at the UConn School of Law and an expert in tax law, predicted the IRS would block Connecticut’s approach.
“The Republicans did not take all the heat from their $10,000 cap on state and local taxes only to passively watch the states do an end run,” he said. “Even if the law was straightforward and clearly on the side of Connecticut, which it is not, you would expect the IRS to issue a ruling shutting down the proposed approach.
“Taxpayers can, of course, choose to litigate the issue, perhaps appearing before Trump-appointed judges, but most will not,” Pomp said. “As a practical matter, an adverse ruling by the IRS will shut down this approach.”
Malloy made the announcement during the release of his budget proposal on Monday. He said an estimated 181,000 Connecticut taxpayers took a state and local tax deduction greater than $10,000 and stand to lose more than $10 billion in deductions.
“It would be unreasonable for us as a state to not propose ways to assist our taxpayers,” Malloy said.
Malloy said his office had language that would be sent to lawmakers to consider during the legislative session that begins Wednesday. The plan is to have the option available to taxpayers for federal taxes that come due in April 2019.
“We believe the steps that we are taking are permitted,” under federal tax law, Malloy said.
Kevin Maloney, a spokesman for the Connecticut Conference of Municipalities, said the organization, which lobbies on behalf of cities and towns, had been looking at such a proposal.
But other municipal leaders in Connecticut were more wary of the governor’s approach.
“We are concerned … that there is a tremendous amount of uncertainty regarding how the IRS will treat such contributions,” said Betsy Gara, executive director of the Connecticut Council of Small Towns.
Sen. Richard Blumenthal, who along with the rest of the state’s Democratic congressional delegation fought the tax plan, credited the Malloy administration with a novel approach to protecting state taxpayers.
Rep. John Larson, who sits on the tax-writing Ways and Means Committee, urged the General Assembly to adopt Malloy’s proposal.
Connecticut is one of just a handful of states that are looking at potential workarounds to the cap on state and local tax deductions. California has proposed a similar approach, with a state-run charity that would provide donors credits against their state income tax.
“There are a wide variety of states that are considering a variety of options,” said Kevin Sullivan, commissioner of the state Department of Revenue Services.
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